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Cost is king, passives are core, and sustainable alpha is key says Cerulli


The latest report from research firm Cerulli Associates finds that the crackdown on "closet trackers" is gathering pace in Europe.

The firm reports that concerns are growing that the metric used to identify those funds that charge active management fees while replicating an index could undermine performance. 

Cerulli notes that European regulators are taking a greater interest in the issue. The firm writes: “In May the Swedish government launched an investigation in the wake of the Swedish Shareholders' Association filing a lawsuit against a leading fund house, alleging that it had mis-sold closet trackers to retail investors. Regulators in Denmark and Norway have also been proactive.”

The firm finds that more managers are voluntarily disclosing data showing the extent to which a fund's portfolio diverges from its benchmark. "Active share" is the most commonly used measure, with a score less than 60 per cent deemed to be index hugging.
"Active share, however, is no panacea and used in isolation is more likely to be misleading. It should be used alongside other relevant metrics, such as information ratio data showing the portfolio returns above the benchmark in relation to the volatility of those returns," says Barbara Wall, Europe research director at Cerulli Associates.
Noting that there are times in an investment cycle when it might be prudent to stay close to the benchmark, Cerulli warns that a manager who feels obliged to maintain a certain active share is at risk of picking the wrong stocks simply to increase the deviation from the benchmark. Strict adherence to the tool may also prevent a manager from buying stocks that have a large weight in the index, even if they are expected to outperform.
Another limitation that the firm notes concerns the definition of being "active", which typically refers to the actual shares that are owned. But "active" can also apply to a portfolio that largely adheres to the index, provided the manager has not simply taken a buy-and-hold approach and that performance is influenced by the timing of trades in those constituents.
“Firms that are already disclosing the active share figure tend to have house management styles that are unconstrained in relation to benchmarks” Cerulli writes. “Firms where the emphasis is on delivering outperformance with a relatively low-risk, low-active share element would be understandably anxious about publishing their active share figure.”
"They would also point out, with some justification, that a low active share doesn't mean they are a closet tracker and that they should be judged on performance alone," says Wall.
Cerulli believes that, used in conjunction with other metrics, active share can be a useful tool in promoting accountability and transparency. Laura D'Ippolito, a senior analyst at Cerulli, says: "Views within the European fund industry on the value of the active share figure differ widely, but what is clear is that the debate, which also takes in the active/passive issue, is only going to intensify."
Turning to ETFs, Cerulli comments that they are at long last gaining traction in the US. “Active mutual fund managers should seriously consider offering their strategies in these securities,” advises Cerulli. The firm notes, however, that the path to success remains difficult. Another structure the firm recommends is the new exchange-traded managed fund.
In the UK, active management is no longer the be-all and end-all for discretionary investment managers, says Cerulli, noting that a combination of regulatory change and the low-growth environment is forcing firms to review costs and portfolios. “Not only are passive funds now more common in discretionary portfolios, but their role, and that of active funds, is changing. The analytics firm says that active managers face a challenge in staying relevant in a world in which cost is king, passives are core, and sustainable alpha is key.

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